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What Causes Macroeconomic Instability and is the Economy "Self-Correcting"?
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En provenance du cours de University of California, Irvine
The Power of Macroeconomics: Economic Principles in the Real World
1399 notes
University of California, Irvine
1399 notes
À partir de la leçon
The Warring Schools of Macroeconomics
Rencontrer les enseignants
Dr. Peter NavarroProfessor
Paul Merage School of Business
[MUSIC]
There are three important questions we have to
ask to fully evaluate the warring schools of macroeconomics.
Number one, what causes instability in the economy
so that it deviates from its full employment output?
Two, is the economy self correcting, and if so, what
is the speed of the adjustment back to full employment output?
And three,
should the government adhere to a set of hard and fast
rules, or rather use discretion in setting fiscal and monetary policy?
So let's start with the first question.
What can drive an economy away from its full employment output?
The main stream view is Keynesian based.
It holds that instability in the economy arises from two sources.
The first,
most common problem is significant changes in investment spending.
And to a lesser extent consumption
spending, both of which change aggregate demand.
The second more occasional problem is adverse supply side shocks
which change aggregate supply. Now in contrast to the
Keynesian view, the Monetarists hold that it is inappropriate government policies
that are the major cause of macroeconomic instability.
In fact, modern monetarism is a classically based perspective.
This is because, like classical economics, monetarism argues
that the price and wage flexibility provided by competitive
markets cause fluctuations in aggregate demand to alter
product and resource prices, rather than output and employment.
The problem, as Monetarists see it, is that wages
can't adjust freely downward because of government policies, ranging
from minimum wage and pro-union legislation, to guaranteeing prices
for farm products, pro-business monopoly protections, and so on.
Even more importantly, the Monetarists also blame the
government's clumsy and often misguided attempts to achieve greater
stability to activists monetary policies.
This problem of a misguided government is rooted
in the Monetarists view of the economy through the
lens of the Equation of Exchange and quantity
theory of money, which we examined in lecture four.
You may recall from that lecture that if the velocity of money v is
stable, and real output q is independent of the price level, changes in the money
supply m can only lead to changes in inflation.
Of course it is a matter of some debate
as to whether the velocity of money is stable.
And in fact Keynesians take the view that velocity is actually unstable.
From the perspective of supply side economics, supply siders agree with
the Keynesians that macroeconomic instability
can result from supply side shocks.
However, in this regard supply siders at least partly
share the classical and monetarist view that it is
often the government, not just droughts and oil price
hikes, that is to blame for causing the shocks.
Of particular concern to the supply siders are
high tax rates and regulations that reduce supply incentives.
Let's turn now to our second area of controversy,
the question of whether the economy self corrects.
In this debate, it not just a question of
whether an economy corrects itself when instability does occur,
economists also disagree as to the length of time
it will take for any such self correction to happen.
In this regard, both the monetarists and the new
classical economists take the view that when the economy occasionally
diverges from its full employment output, internal mechanisms within
the economy automatically move it back to that output.
This perspective is associated with the theories of
adaptive and rational expectations that we have already discussed.
This figure relates the new classical view of self correction.
Here, an unanticipated increase in aggregate demand
from AD1 to AD2 moves the economy from point A to point B.
This causes the price level to rise from P1
to P2, as real output increases from Q1 to Q2.
Now, in a new classical world, what do you
think happens next to bring the economy back to Q1?
And what do you think will happen to the price level.
In the long run, nominal wages will rise to
restore the real wages that have been eroded by inflation.
This causes per unit production cost to rise, and eventually the short run
aggregate supply curve shifts leftward and inward, from AS1 to AS2.
As the economy moves from point b to point c, the price level rises from P2 to P3,
and the economy returns to the full employment level of Q1.
Now what about the speed of adjustment issue?
Well here there is much controversy,
even within the various schools of macroeconomics.
For example, classically orientated monetarists usually hold
the adaptive expectations view that people form
their expectations on present realities, and only
gradually change their expectations as experience unfolds.
This implies
that the shifts in the short run aggregate supply curves that we have
just illustrated, may not occur for two or three years or even longer.
On the other hand, the new classical economists accept the rational
expectations assumption that workers anticipate some
future outcomes before they even occur.
This suggests that when price level
changes are fully anticipated, the adjustments
in our figures occur very quickly, indeed even instantaneously.
So what do the Keynesians think about all this?
Well, almost all economists today
acknowledge that new classical economics has
taught us some important lessons about the theory of aggregate supply.
None the less, most mainstream economists strongly disagree
with new classical rational expectations theory on the question
of downward price and wage flexibility.
In this regard, while the stock market,
foreign exchange market and certain commodity markets
experience day to day or even minute
to minute price changes, including price declines.
This is not true in many product markets, and in most labor markets.
Indeed, there appears to be ample
evidence, say mainstream economists, that many
prices and wages are inflexible downward for long periods.
As a result, it may take years for an economy to move from recession
back to full employment output, unless it gets help from fiscal and monetary policy.
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